It's Never Too Early to Save for Your Kids

Parents everywhere hope to put their children on a path to prosperity.

That's why some go to extremes. For instance, there are parents who will dish out as much as $40,000 to college admissions consultants to help their child gain entry to an Ivy League school, according to a recent New York Times report.

But I've got a better -- and cheaper -- way to ensure a secure financial future for little Johnny or Mary. Put them to work early in life, help them open a Roth IRA and make some modest contributions on their behalf.

Then sit back and let the powerful combination of time and tax-free compounding do its work in the decades ahead. For just a few hundred dollars a year, Mom and Dad can provide a secure financial foundation for years to come.

Figures outlined recently in the Journal of Financial Planning illustrate how just how this strategy can work.

In an article titled "The Roth IRA for Children: Multigenerational Wealth Planning," one example shows how nine $500-a-year contributions from ages 10 to 18 (total contributions: $4,500) could accumulate to about $112,000 by age 60, assuming a 7.2 percent annual growth rate.

Meanwhile, $500 a year contributions beginning at age 22 and ending at age 59 (total contributions: $19,000) would grow to only $97,000 under the same 7.2 percent growth rate, according to Mark G. Haug and Adrienne G. Cichelli, the article's authors.

The reason for the difference is from the sheer impact of time, the most powerful advantage any investor can have.

As many readers are aware, Roth IRAs are retirement savings accounts with powerful tax advantages. These include tax-free withdrawals in retirement and freedom from required withdrawals after age 70½ as exists with traditional IRAs.

The tradeoffs are early withdrawal penalties before 59½ and no upfront tax savings when contributing to a Roth IRA, unlike a 401(k), traditional IRA or most other retirement savings plans. But given the likelihood of higher tax rates in the future in light of the nations' federal budget deficit, a Roth IRA is a good way to shield one's self from future taxes.

Most individuals are well into their working lives before they consider opening a Roth IRA even though the younger the person is, the more he or she is likely to benefit from the tax-free growth. That's why a Roth IRA is a terrific opportunity for a child.

The primary requirement for anyone -- including a child -- to open a Roth IRA is that the person must have earned income from some type of work during the tax year they contribute. There's no minimum age required.

That means a kid who delivers newspapers, babysits, works in a family business or holds a part-time job can contribute to a Roth IRA regardless of age. Of course, this income will have to be reported to the IRS. But if the child's taxable income is less than his or her standard deduction ($5,700 for 2009), then no income taxes will be due, though Social Security and Medicare taxes could be an issue.

For many children, that could mean no taxes on the front end when a Roth IRA contribution is made and no taxes on the back end when withdrawals are made in retirement.

For information on IRS filing requirements for children, visit IRS.gov and search for the page titled "Taxable Income for Students." Yes, the filing requirements for a child's income to qualify for a Roth contribution are an added headache come tax filing season, but it is a headache worth incurring.

The current maximum annual contribution to a Roth IRA is $5,000 ($6,000 for individuals 50 and over), but the contribution amount cannot exceed an individual's earned income in a given tax year. For example, a $500 annual contribution to a child's Roth IRA will require the child have earned income of at least $500 in the year of contribution.

As the parent of children now old enough to earn a little money, I know trying to convince a teen or preteen to turn over their earnings for a retirement account is a tall order. But there is nothing to stop Mom, Dad or another relative from funding the contribution themselves.

So my bottom line recommendation is that if you have a child old enough to earn a few bucks, consider opening a Roth IRA on their behalf and make a modest annual contribution from your own funds for a few years.

Given the child's long investment horizon, I'd invest the money entirely in a stock mutual fund, preferably a low-cost mutual fund that tracks either the total U.S. stock market index fund or the large Standard & Poor's 500 Index.

Then do everything in your power to keep Johnny or Mary from tapping into that Roth IRA prematurely to ensure they stay on the path to prosperity you've laid out for them.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.